Thursday, June 27, 2013

A stock market addicted to stimulus

Was
former Fed Chairman Paul Volcker correct when he said concerning quantitative
easing that its “beneficial effects…appear limited and diminishing over
time”? That’s the $85 billion question
that Wall Street is asking right now. An
honest answer to this question by current chairman Bernanke will do much to
allow the economy to heal itself of the wounds inflicted by the excesses of the
last 10 years.

It
became clear starting in May that the bond market is pricing in, by way of
increasing yields, “the complete elimination of quantitative easing, even
though elimination is the ultimate goal” in the words of Barron’s columnist Gene Epstein.
The Fed thus finds itself confronted with a paradox: it commenced its
quantitative easing (QE) policy to help the economy stabilize and regain its
strength, yet the mere threat of withdrawal of stimulus after more than four
years has spooked investors. Judging
from the reaction of the stock market since last month, it’s clear that Wall
Street can’t live without QE.

This
begs the question of how effective QE has been in allowing the economy to build
structural strength since the job market is still weak and middle class incomes
haven’t recovered since the credit crisis began. The middle class is the backbone of the
economy and without its active participation no economic recovery can be
considered effectual.

After
four-and-a-half years of QE we can draw some conclusions about QE’s
usefulness. First, QE can be likened to
a stimulant administered to an auto crash victim who needs time and rest, above
all, to regain health. The stimulus may
trick the body into thinking that recovery is happening faster than nature
intended, but the attempt at short-circuiting natural processes only provides a
temporary metabolic boost and does nothing to address fundamental health
issues.

Secondly,
QE does indeed, as Volcker suggested, provide only diminishing returns. The recent experiences of China and the U.S.
as well as Japan’s 20% stock market plunge bear this out. QE has also failed to provide the promised
boost to employment and has resulted mainly in increased consumption among
higher end consumers; its benefits have largely passed over middle and lower
class consumers.

Finally,
the basic assumption that QE would benefit corporations, which in turn would
use the increased revenues to expand their workforce, has proven to be a
false. While QE did indeed expand
corporate profits by boosting stock prices, those profits were used by
corporations to cut their workforces through various efficiency measures. Moreover, the profits of the largest
multinational firms were hoarded in overseas banks instead of being directly
re-invested into domestic production.
America’s working force has seen precious little of those record profits
while the corporate state has expanded at the expense of working class
taxpayers.

As
if all of that weren’t enough, we’re now faced with the perverse possibility
that a “tapering” of the Fed’s stimulus measures may result in considerably
lower stock prices down the line. This
in turn would undo a substantial part of the recovery on the high-end of the
economic scale, thereby undermining the entire 5-year experiment with QE.

While
it’s true that American households now have a cumulative net worth of $70
trillion, a new record, those gains are mainly due to the benevolent effects of
QE in increasing retirement funds and real estate values. Robert J. Samuelson, writing in the Washington
Post, pointed out that before the 2008 financial crisis, Americans tended to
spend about 5 cents of every dollar they gained in housing and stock
wealth. They now spend half that amount
at best. The reason for this, said
Samuelson, is that households still haven’t recovered from the losses they
suffered 5-6 years ago. Meanwhile house
prices are still 22 percent below their 2006 peak values.

More
importantly, psychology plays a major factor in curtailing consumption among
U.S. households. “Careless optimism has
given way to stubborn cautiousness,” writes Samuelson. “Americans learned the hard way that houses
and stocks are risky assets,” he says, and they’re no longer borrowing against
their wealth the way they used to. He
calls this a “stunning shift in behavior” and points out the predicament it
creates for policy makers, viz. how to promote growth when people have embraced
a defensive posture while “building barriers against hazards they can’t
foresee.”

Bernanke’s
recent suggestion that the Fed may start “tapering” the stimulus later this
year throws in sharp relief his failure to recognize not only Wall Street’s
addiction to stimulus, but also the deflationary counterforce of the 120-year
cycle. The Fed has succeeded in
re-inflating stock and real estate values because it fought relentlessly against
this long-term cycle for over four years.
To relent now would be to allow deflation to have its way heading into
2014 when the cycle finally bottoms.